Thursday, April 21, 2005

Last week, The Economist ran a lengthy article on flat taxes, making a persuasive case for them. This is not just an eccentric idea that appeals to nutty right-wingers. Unbeknownst to most, eight Eastern European nations –including Russia--have already adopted flat taxes, with good results.

No one can deny flat taxes have many things in their favor compared with the traditional multi-bracket income tax. First of all, they’re much easier to collect, which saves the government a lot of money by reducing administrative costs and tax evasion. In addition, they save the average taxpayer a lot of time, money and anguish. Last but not least, a flat tax system makes it a lot harder for politicians to intervene in resource allocation by handing out tax breaks to favored industries and constituents.

So why aren’t people in the rich nations clamoring for them? As any self-respecting liberal (in the American sense) will tell you, flat taxes seem unfair. For decades, the idea that the more you earn, the more you should pay in taxes has been firmly rooted in the Western world. This is so despite mounting evidence that the rich end up paying about the same share of income as the middle class since they have the resources to exploit the mind-numbing complexity of the tax code.

When simplicity and efficiency battle fairness, the latter wins hands down in most people’s minds. However, is this perception justified?

The main problem in all debates concerning the fairness taxes is that they ignore the flip side of the coin: public spending. Clearly, having a “progressive” tax system is of little use is spending is regressive. In other words, taxing the rich doesn’t advance the cause of social justice if they end up receiving most government spending. Admittedly, this is a rather extreme case (in the rich world; my impression is that in many developing nations this may be sadly true).

Thinking along these lines offers a solution, a “third way” so to speak: adopt flat taxes, but at the same time review and change public spending to make it more progressive. This is a win-win solution: everyone benefits by having simpler taxes and the needy get more public money.

In addition, this idea will also have an additional benefit. Incredible as it seems, today, hardly anyone knows the general distributional impact of government spending nor is it a point taken much into account by policymakers, despite its obvious importance. By linking tax policy to spending in terms of fairness, this will have to change.